Chapter 7 - CAPM & APT, Multiple Choice Questions for Investments quiz, Investments quiz 2 part #2, Investments Quiz #2 Part 1
security characteristic line (SCL)
a plot of a security's expected excess return over the risk-free rate as a function of the excess return on the market
well-diversified portfolio
a portfolio sufficiently diversified that nonsystematic risk is negligible
arbitrage pricing theory (APT)
a theory of risk-return relationships derived from no-arbitrage considerations in large capital markets
factor portfolio
a well-diversified portfolio constructed to have a beta of 1 on one factor and a beta of zero on any other factor
arbitrage portfolio
a zero-net-investment, risk-free portfolio with a positive return
excess return
rate of return in excess of the risk-free rate
asset allocation
portfolio choice among broad investment classes
According to the capital asset pricing model, a security with a _________.
positive alpha is considered underpriced
Scenario Analysis
process of devising a list of possible economic scenarios and specifying the likelihood of each one, as well as the HPR that will be realized in each case
mean-variance analysis
Evaluating portfolios according to their expected returns and standard deviations (or variances).
Risk premium
Expected return in excess of that on risk-free securities
Variance
Expected value of squared deviation from mean
Scenario analysis
Possible economic scenarios; specify likelihood and HPR
Holding-Period Return (HPR)
Rate of return over given investment period
Risk-free rate
Rate of return that can be earned with certainty
The Sharpe (Reward-to-Volatility) Ratio
Ratio of portfolio risk premium to standard deviation
Price of risk
Ratio of risk premium to variance
Risk aversion
Reluctance to accept risk
The graph of the relationship between expected return and beta in the CAPM context is called the _________.
SML
Standard deviation
Square root of variance
Excess return
rate of return in excess of the risk-free rate
Holding Period Return (HPR)
rate of return over a given investment period
Sharpe (or reward-to-volatility) ratio
ratio of portfolio risk premium to standard deviation
risk aversion
reluctance to accept risk
inflation rate
the rate at which prices are rising, measured as the rate of increase of the CPI
risk free rate
the rate of return that can be earned with certainty, often measured by the rate on Treasury bills
Price of risk
the ratio of portfolio risk premium to variance
According to the capital asset pricing model, fairly priced securities have _________.
zero alphas
Which of the following is a correct expression concerning the formula for the standard deviation of returns of a two-asset portfolio where the correlation coefficient is positive?
σ2rp > (W12σ12 + W22σ22)
Annualizing Rates of Return
• APR = Annual Percentage Rate • EAR = Effective Annual Rate
EAR = Effective Annual Rate
• Actual rate an investment grows • Does not ignore compounding
Value at risk (VaR)
•Measure of downside risk •Worst loss with given probability, usually 5%
Variance
the expected value of the squared deviation from the mean
dollar-weighted average return
the internal rate of return on an investment
expected return
the mean value of the distribution of HPR
market portfolio
the portfolio for which each security is held in proportion to its total market value
Asset A has an expected return of 15% and a Sharpe ratio of .4. Asset B has an expected return of 20% and a Sharpe ratio of .3. A risk-averse investor would prefer a portfolio using the risk-free asset and
Asset A. This is because the higher the value of sharpe ratio, the greater is the ability of the stock to provide a good risk adjusted return.
Suppose that a stock portfolio and a bond portfolio have a zero correlation. This means that ______
B. the returns on the stock and bond portfolios tend to vary independently of each other
The optimal risky portfolio can be identified by finding
III. The tangency point of the capital market line and the efficient frontier IV. The line with the steepest slope that connects the risk-free rate to the efficient frontier
Dollar-weighted average return
Internal rate of return on investment
Expected return
Mean value
Arithmetic average
Sum of returns in each period divided by number of periods
real interest rate
The excess of the interest rate over the inflation rate. The growth rate of purchasing power derived from an investment.
Which statistics cannot be negative?
Variance
HPR = (Ps - Pb + Div)/Pb
Where Ps = Sale Price Pb = Buy Price Div = Cash Dividend
You are constructing a scatter plot of excess returns for stock A versus the market index. If the correlation coefficient between stock A and the index is -1, you will find that the points of the scatter diagram ___________ and the line of best fit has a ______________.
all fall on the line of best fit; negative slope
. According to the capital asset pricing model, a fairly priced security will plot _________.
along the security market line
risk premium
an expected return in excess of that on risk-free securities
The _______ decision should take precedence over the _____ decision
asset allocation, stock selection
arbitrage
creation of riskless profits made possible by relative mispricing amond securities
Building a zero-investment portfolio will always involve _____________.
equal investments in a short and a long position
Consider an investment opportunity set formed with two securities that are perfectly negatively correlated. The global minimum-variance portfolio has a standard deviation that is always _________
equal to 0
If enough investors decide to purchase stocks, they are likely to drive up stock prices, thereby causing _____________ and ___________.
expected returns to fall; risk premiums to fall
security market line (SML)
graphical representation of the expected return-beta relationship of the CAPM
According to Tobin's separation property, portfolio choice can be separated into two independent tasks consisting of __________ and __________.
identifying the optimal risky portfolio; constructing a complete portfolio from T-bills and the optimal risky portfolio based on the investor's degree of risk aversion
Decreasing the number of stocks in a portfolio from 50 to 10 would likely ________________.
increase the unsystematic risk of the portfolio
expected (mean) return-beta relationship
inplication of the CAPM that security risk premiums (expected excess returns) will be proportional to beta
passive strategy
investment policy that avoids security analysis; often entails indexing
probability distribution
list of possible outcomes with associated probabilities
Beta is a measure of security responsiveness to _________
market risk
skew
measure of the asymmetry of a probability distribution
multifactor models
models of security returns that respond to several systematic factors
Diversification is most effective when security returns are
negatively correlated
An investor's degree of risk aversion will determine his or her ______.
optimal mix of the risk-free asset and risky asset
Capital Allocation Line (CAL)
plot of risk-return combinations available by varying portfolio allocation between a risk-free asset and a risky portfolio
If an investor does not diversify his portfolio and instead puts all of his money in one stock, the appropriate measure of security risk for that investor is the ________.
stock's standard deviation
According to CAPM, investors require a risk premium as compensation for bearing ______________.
systematic risk
alpha
the abnormal rate of return on a security in excess of what would be predicted by an equilibrium model such as the CAPM
geometric average
the single per-period return that gives the same cumulative performance as the sequence of actual returns
standard deviation
the square root of the variance
arithmetic average
the sum of returns in each period divided by the number of periods
The expected rate of return of a portfolio of risky securities is
the weighted sum of the securities' expected returns
. Many current and retired Enron Corp. employees had their 401k retirement accounts wiped out when Enron collapsed because ___.
their 401k accounts were not well diversified
The correlation coefficient between two assets equals _________.
their covariance divided by the product of their standard deviations
Standard deviation of portfolio returns is a measure of ___________.
total risk
Risk that can be eliminated through diversification is called ______ risk
unique firm-specific diversifiable
The term complete portfolio refers to a portfolio consisting of _________________.
the risk-free asset combined with at least one risky asset
In a well-diversified portfolio, __________ risk is negligible
unsystematic
Adding additional risky assets to the investment opportunity set will generally move the efficient frontier _____ and to the ______.
up; left
APR = Annual Percentage Rate
• Per-period rate × Periods per year • Ignores Compounding
U.S. History of Interest Rates, Inflation, and Real Interest Rates
• Since the 1950s, nominal rates have increased roughly in tandem with inflation • 1930s/1940s: Volatile inflation affects real rates of return
Geometric average
• Single per-period return • Gives same cumulative performance as sequence of actual returns • Compound period-by-period returns
capital asset pricing model (CAPM)
a model that relates the required rate of return on a security to its systematic risk as measured by beta
Value at Risk (VaR)
Measure of downside risk. The worst loss that will be suffered with a given probability, often 1% or 5%
Kurtosis
Measure of the fatness of the tails of a probability distribution relative to that of a normal distribution. Indicates likelihood of extreme outcomes.
Probability distribution
Possible outcomes with probabilities
Arbitrage is based on the idea that _________.
assets with identical risks must have the same expected rate of return
In the context of the capital asset pricing model, the systematic measure of risk is captured by _________.
beta
An adjusted beta will be ______ than the unadjusted beta
closer to 1
The ________ is equal to the square root of the systematic variance divided by the total variance.
correlation coefficient
The _________ reward-to-variability ratio is found on the ________ capital market line.
highest; steepest
A measure of the riskiness of an asset held in isolation is ____________.
standard deviation
mutual fund theorem
states that all investors desire the same portfolio of risky assets and can be satisfied by a single mutual fund composed of that portfolio
An important characteristic of market equilibrium is _______________.
the absence of arbitrage opportunities
Capital Market Line
the capital allocation line using the market index portfolio as the risky asset
capital allocation to risky assets
the choice between risky and risk-free assets
The beta of a security is equal to _________.
the covariance between the security and market returns divided by the variance of the market's returns
complete portfolio
the entire portfolio including risky and risk-free assets
nominal interest rate
the interest rate in terms of nominal (not adjusted for purchasing power) dollars